Different Tools

Both microeconomics and macroeconomics start with the assumption that people respond to incentives (or as economists are more likely to say, individuals are self-interested and make decisions on the basis of costs and benefits).1 But the different topics they address require different simplifying assumptions. As a result, macroeconomic theory appears to be somewhat different from microeconomic theory.

To understand the methods used in both, one must first realize that theory is a creation of the human mind. It is our attempt to impose order on the world around us. Theory is like a map. A good map shows how pieces of geography fit together, but omits large amounts of detail. It simplifies the world so that our minds can use the information it contains.

Economic reality is more complex than any human mind can completely understand. To be useful, economic theory must give us a simplified picture of this reality. In microeconomics the usual way to simplify is to use partial equilibrium analysis. Partial equilibrium analysis assumes that we can look at part of the system in isolation, ignoring the rest. Strictly speaking, this assumption is rarely if ever true. What happens to the apple market may affect the orange market, and these effects may in turn come back to affect the apple market. But indirect effects of this sort are often small enough to ignore, especially when one does not worry about the adjustment process. Microeconomics usually begins with the assumption that the economy is at equilibrium, that is, all markets clear. It then investigates properties of this equilibrium.

In macroeconomics, however, these indirect effects are interesting and important because economists have found that problems visible in one set of markets very often have their origin in another set. The human mind, however, cannot work through the interactions of the millions of markets that make up a real economy. If the economy had only three of four markets, the patterns of interaction would be simple enough to understand. Economists create this simple economy of only a few markets by combining together, or aggregating, many thousands or millions of markets that microeconomics looks at separately.

Microeconomics also aggregates, but not in the drastic way macroeconomics does. Although the prefix micro suggests that microeconomics deals with small units, such as individual consumers and sellers, it does not. It does discuss how idealized individuals act, but only to use the results for predicting what groups will do. And in discussing what groups do, it aggregates. Thus economics does not predict what Adrienne Hrycyk will do if the price of apples increases by 10% due to a bad harvest. It does predict that consumers as a group will buy fewer apples. Individual behavior involves many variables and price may not be the most important. When groups become large enough, the special circumstances of each individual tend to cancel out, and the role of price dominates all other factors.

However, macroeconomics does not just lump together all the buyers or sellers of one product: it lumps together completely separate markets. It combines millions of markets into a fewoften just two, three, or four. In a sense economists replace apples, oranges, cars, and haircuts with a composite good and discuss the market for goods and services, and they replace accountants, lawyers, masons, and waitresses with a composite item and discuss the labor market. This procedure may seem extreme, but economic measurements such as rates of inflation and unemployment make sense only if this procedure is accepted.

A recital of problems does not tell us anything about their causes. To examine causes, we need theory to interpret the facts. Unfortunately, in macroeconomics there remains a substantial amount of disagreement among economists about what theory organizes the facts best. Topics of macroeconomics are usually more controversial than topics in microeconomics.

1This statement was not true fifty years ago when microeconomics and macroeconomics were seen as two separate branches of economics. Since then much effort has gone into uniting them by giving macroeconomics a foundation in microeconomics.